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Digital Assets (DA) such as cryptocurrency, DeFi, Web3.0 and tokenization have swiftly moved from a fringe speculative investment niche into the forefront of the investment world, which is further evidenced by the approval by the SEC of spot Bitcoin ETFs in January.
Whether you like it or not, these assets are here to stay, and as an RIA you likely have multiple clients inquiring about them. You have several options for managing these assets, which present two important questions: “How do I manage this risk, and does my E&O (errors & omissions) insurance cover these investment recommendations?”
The most important thing to understand about the investment advisor E&O marketplace is that all carriers have different coverage forms and underwriting appetites. There are two basic underwriting categories of carriers: conservative versus liberal (i.e., DA deemed acceptable). Since DA has only recently become popular with the public, the insurance underwriting marketplace is still trying to determine how it wants to cover or exclude these investments. As a sidenote, this is ever-changing and evolving and not all DA strategies are viewed the same.
Recently, we held roundtable talks with 10 key insurance carriers to talk through the DA exposures, grasp their current viewpoints, appetites, and establish some underwriting guidelines so we can all move forward successfully (insureds and insurers). Overwhelmingly, many of the key carriers open to higher risk-investment strategies confirmed – as our office interpreted in their contract forms – that DA is not excluded. The more conservative carriers, who often already have specific exclusions surrounding DA, are open to insuring DA in specific scenarios based on how the RIA is managing assets in the space.
As an aside, overwhelmingly, the greatest concerns among underwriters were (1) custody of digital assets (2) clarity regarding DA regulation (3) safekeeping of DA within various custodial platforms and (4) advisor experience/expertise in the asset class (in other words, is the advisor qualified to manage this asset class?).
Now that we have an overview on the marketplace, how do we determine if coverage is provided by a carrier? This depends largely on how you plan to incorporate (or have already incorporated) DA into your firm’s operations. The following are some ways you can advise clients around this investment class:
Option 1: Financial planning that incorporates currently held DA into overall portfolio recommendations. In this case, you will find insurance carriers, both conservative and liberal, are more comfortable covering this risk. Especially if you are not directly billing on DA, many of the conservative carriers have endorsements to provide affirmative coverage for financial planning recommendations.
Option 2: Investing into the asset class through a liquid security that tracks DA in some form (spot ETF, mining stocks, companies that invest into blockchain assets, etc.). If you take this approach, both conservative and liberal underwriters are willing to provide coverage. It is very important that you understand the specific structure of the investment product(s) you are recommending. For example, some conservative underwriters will deem a spot bitcoin ETF acceptable yet something like the Greyscale Ether Trust, at this juncture, is not acceptable.
Option 3: Direct management of digital assets. If you plan to take this approach, underwriting can be more complex. If you are insured with a carrier who is open to higher-risk strategies, they will typically desire total AUM in this category to be 10 percent or less of total assets. If you help clients directly manage their DA, carriers currently consider this a higher underwriting risk; expect more underwriting questions, as well as potentially higher premiums and deductibles.
If you happen to be insured by one of the carriers that specifically excludes DA recommendations, make sure that your insurance broker understands the risk-management protocols the firm employs to help mitigate your exposure to client complaints. If you are proactively controlling risk, there is a higher likelihood coverage can be acquired. For underwriters to consider offering coverage for direct investment into DA, you should have the following proactive measures in place:
- A good compliance program surrounding these assets, including ADV disclosures;
- A general maximum allocation to digital assets for specific clients rather than rolling it out to all clients regardless of risk tolerance; and
- Additional client disclosures where clients acknowledge the risk/volatility within the space.
Even with the above, if insured by a conservative carrier, be prepared for an additional premium charge to obtain DA coverage extension, or potentially not being able to secure coverage.
Since carriers are still digesting and figuring out how they want to cover DA, investment advisors should focus on working with a broker who understands this space. What was true six months ago, can easily be different now and in further down the road.
Golsan Scruggs is a corporate insurance brokerage firm serving the financial services industry. Our specialists operate throughout the United States and specialize in registered investment advisor (RIA), private equity/hedge fund, and mutual fund professional liability errors & omissions (E&O) insurance. As one of the largest insurers of RIA firms in the U.S., Golsan Scruggs employs a dedicated staff that understands the special risks of the financial services industry to achieve superior results, making the underwriting process painless.
Cameron Norris is a shareholder and vice president with the firm.
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